To manage steep gains, advisers need to open the tax toolbox

This year's big stock market gains are forcing advisers to think about how to help their clients contend with a potentially stiff capital gains tax bite from mutual fund distributions.

Investors holding mutual funds in taxable accounts are liable to be taxed on the distributions that mutual funds often make after selling securities. Those distributions are taxed as either short-term gains from securities held for a year or less, or long-term gains for securities held more than a year.

”If you have an actively managed mutual fund with a high turnover ratio, you may be getting a large taxable distribution,” said Richard Gotterer, a managing director and senior financial adviser with Wescott Financial Advisory Group. “So this is something that merits a look.”

Mutual funds' fiscal years typically end Oct. 31 and they begin releasing preliminary estimates for distributions in November.

While the sharp stock market gains — the S&P 500 index is up around 25% for the year — means strong returns for investors, it also means higher mutual fund distributions. In addition, investors are facing higher capital gains rates. Short-term capital gains are taxed at the same rate as ordinary income, so the highest bracket is 39.6%, compared with 35% in 2012. For the highest bracket, long-term capital gains rates are at 20%, up from 15% last year.

Advisers do have tools to help clients minimize the IRS' impact, however.

For instance, clients can assess the size of their mutual fund distribution, consider how long they've been a shareholder in the fund — namely, whether their gains would be considered long-term or short-term — and then sell their holdings to miss the distribution, Mr. Gotterer said.

If the client has incurred a loss, he or she can then buy back into the fund after 30 days so the transaction is not considered a wash sale, which carries other tax consequences.

“The value of the fund's shares will fall by the amount of the distribution, so you buy it back after that occurs so you don't collect the taxable distribution,” he said.

This tactic isn't right for everyone. For one thing, it doesn't make sense if the fund isn't in a taxable account, and the distribution from the fund has to be sizable to be worth the legwork.

“You need to see whether the funds will have an extraordinary capital gains distribution,” Mr. Gotterer said. “And you need to see if there is an arbitrage between taking the capital gain versus taking the distribution from a tax perspective: Which one is more beneficial?”

Another way to minimize the bite from capital gains taxes is to look for loss carry forwards from the past. Capital losses can be reported up to seven years after they occurred. Some investors may al! so be able to harvest losses, noted Robert S. Keebler, a partner with Keebler and Associates. “You want long-term losses to offset short-term gains; that's your best arbitrage,” he said.

Those losses, used wisely, can also help knock an investor into a lower tax bracket, Mr. Keebler said.

In fact, back in 2008, the silver lining in the market's dismal performance for many investors was the fact that they could take stock market losses and use them to soften the capital gains tax blow they would be facing when the market climbed in subsequent years, Mr. Gotterer said.

By now, however, those losses have been used up.